The role of trade credit financing in international trade
Katharina Eck, Martina Engemann, Monika Schnitzer
Credits extended bilaterally between firms, so called trade credits, are particularly expensive yet many firms utilize it, specifically for international transactions. This column argues that such cash-in-advance financing serves as a credible signal of quality. Data from a distinctive survey of German firms show that it fosters export participation specifically for firms that generally have the best difficulties in entering foreign markets.
According to a survey by the IMF (2009), about 60% of most international trade transactions are financed via trade credits. Trade credits are extended bilaterally between firms and exist by means of supplier credits and cash-in-advance. A supplier credit is granted from owner of an excellent to the buyer in a way that the customer can delay the payment of the purchasing price for a particular time frame. Cash-in-advance, in contrast, identifies payments manufactured in advance by the customer of an excellent to owner. The intensive usage of inter-firm financing is surprising considering that financial intermediaries such as for example banks are said to be better in providing credit to firms. Inter-firm financing is known as rather expensive with implicit annual trade credit interest levels amounting up to 40% (Petersen 1997).
The literature on trade credits provides various main reasons why firms depend on trade credit financing. Lee (1993) and Long (1993), for instance, are suffering from the warranty for quality hypothesis according to which firms extend a supplier credit to signal product quality with their (domestic) customers. Klapper, Laeven and Rajan (2011) provide empirical evidence that less trustworthy suppliers offer longer payment periods with their buyers. Only recently gets the literature on trade credits taken international transactions into its focus. Schmidt-Eisenlohr (2012), Hoefele et al. (2012) and Antras and Foley (2011), for instance, investigate the optimal selection of trade credit in international transactions. Auboin and Engemann (2014), Olsen (2011) and Glady and Potin (2011) cope with the question how bank-intermediated trade finance such as for example export credit insurance and letters of credit affect international trade. Why trade credits are so prevalent in international trade, despite their high cost, has been little studied up to now.
In recent research (Eck et al. 2015), we explore the role of cash-in-advance financing for the export decision of firms. As opposed to most studies on trade credit financing, we concentrate on cash-in-advance financing rather than supplier credit financing. Cash-in-advance financing must have a stronger signalling function than supplier credits since it must be actively provided by the trading partner whereas a supplier credit could be extorted simply by overstretching the payment period.
We begin from the idea that international transactions have problems with aggravated information asymmetries because of longer distances and difficulties of tracing the foreign trading partner’s behaviour. Building on the warranty for quality hypothesis, we use a signalling model showing that cash-in-advance financing solves both a moral hazard and a detrimental selection problem for an exporter. When exporting her good, an exporter is met with the problem that the foreign, unknown importer may be unable (adverse selection) and unwilling (moral hazard) to cover the exporter’s good, once he has received it. Only if bank financing is available less productive firms may be deterred from exporting since expected profits from exporting usually do not cover the associated costs in presence of high uncertainty. Paying portion of the purchasing price beforehand, however, the importer can signal his “quality” to the exporter in a way that asymmetric information is reduced. Despite the fact that cash-in-advance financing is intrinsically more expensive than bank credits, this disadvantage is a lot more than compensated for by the reduced amount of uncertainty. Expected profits rise and less productive firms can begin exporting.
We use unique survey data on 1,196 German enterprises from the business enterprise Environment and Enterprise Performance Survey in 2004 to check the result of cash-in-advance financing on firms’ export participation. The benefit of this dataset is that it offers a precise way of measuring the application of cash-in-advance by firms which may be the percentage of firms’ sales in value terms paid before delivery from their customers. A drawback is that transaction level data isn’t obtainable in the survey. Therefore, we can not single out cash-in-advance linked to exporting activities in comparison to domestic activities. We thus restrict our analysis to linking the entire usage of cash-in-advance by firms with their export participation decision.
The info reveal that exporters indeed use cash-in-advance financing more intensively than non-exporters. Figure 1 implies that about 44% of most exporters get a positive share of their sales beforehand, whereas only 33% of most non-exporters obtain advance payments. The common share of cash-in-advance received is quite similar for both groups but marginally higher for exporters.
Figure 1 . The application of cash-in-advance financing by exporters vs. non-exporters
We also explore the way the option of cash-in-advance payments by trading partners affects firms’ decision to export. Whether or just how much cash-in-advance financing a company receives is obviously not randomly assigned across firms. It could depend on unknown factors like the degree of uncertainty in regards to to the exporter’s trading partner, for instance. To tackle endogeneity of our variable of interest, we depend on instrumental variable estimation. As a musical instrument for cash-in-advance financing, we utilize the amount of bargaining power a firm has vis-à-vis its customers. The bigger the bargaining power, the much more likely the firm is to get cash-in-advance from its trading partners.
As Table 1, column 1 shows, firms that get a 1% higher share of cash-in-advance have a 15% higher probability to export. Thus exporters indeed appear to reap the benefits of receiving prepayments from their customers. According to your theoretical results, we’d expect that specifically less productive firms reap the benefits of usage of cash-in-advance financing since these firms is probably not in a position to export in the lack of prepayments. Columns 2 and 3 supply the differential impact of cash-in-advance financing on exporting for less and more productive firms, respectively. As less (more) productive firms we define those firms which have a labour productivity level below (above) the median labour productivity level. Less productive firms have a tendency to benefit indeed more strongly from a 1% upsurge in cash-in-advance financing than more productive firms.
Table 1 . Aftereffect of cash-in-advance financing on the probability to export of firms, IV estimation
Note: ***, **, and * denote significance at the 1%, 5%, and 10% level, respectively.
Alternatively, we also test our hypothesis for small vs. large firms with the median number of employees as cut-off. Columns 4 and 5 claim that the result of cash-in-advance financing on export participation is driven by small firms. Small firms that experience a 1% upsurge in their cash-in-advance share can increase their export probability by 15%. On the other hand, larger firms usually do not significantly reap the benefits of additional cash-in-advance.
Taken together, our results strongly support the hypothesis that cash-in-advance financing fosters export participation specifically of these firms that have a tendency to experience greater difficulties in entering foreign markets. Cash-in-advance serves as a credible signal of quality and reduces portion of the high uncertainty in international trade. If asymmetric information makes exporting less profitable, cash-in-advance might help firms overcome productivity frictions if other firms signal their reliability in type of cash-in-advance. Despite higher implied costs, therefore can facilitate entry into exporting, specifically for less productive firms. The strong export fostering effect for German firms regardless of the rather well-developed German credit market points to the existence of high uncertainty in international markets.
Editor’s note: This article solely relates to the task of Katharina Eck and Martina Engemann throughout their PhD at the University of Munich and will not include any opinion of the Federal Ministry for Economic Affairs and Energy nor the Federal Chancellery of Germany.
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